[PwC UK] Uncertain Future of Airlines and Airports

s-m

What is the “new normal” for aviation?

As the major western economies emerge from the turmoil of the global financial crisis, we find ourselves in a strange and uncertain world. Growth rates are disappointing, relative to the experience before 2007. In the UK, economic growth averaged 3% per annum from 1982 until 2007, more than doubling the size of our economy in 25 years. The only comparable period of sustained UK economic growth was the post-war “golden age” of the 1950s and 1960s. But since the trough of the recession in 2009, UK economic growth has averaged not much more than 1% per annum. Other major western economies are also struggling. In the three years 2011–2013, US economic growth is set to average under 2% and the euro area has struggled to register any growth at all. Emerging and developing economies—by contrast— are performing much more strongly. Even though growth has slowed down in some of the emerging superpowers like China and India, the International Monetary Fund (IMF) is still projecting growth of 4.5–5% in the emerging and developing world this year and next.

With strong growth outside the West pushing up energy and energy and commodity prices, we are living in a world of relatively high inflation. And volatility in financial markets is continuing to add to uncertainty about economic prospects and access to finance. These are all features of a “new normal” economy which reflects three big changes in the economic environment from the world we were living in before the financial crisis. The first change is in the financial system. From the 1980s until 2007, western economies enjoyed an era of easy money. The operation of a highly deregulated and liberalised global financial system provided consumers and businesses with relatively easy access to finance and allowed a build-up of debt. Now, banks have become much more cautious and their reluctance to lend is being reinforced by new regulatory requirements. The second change is affecting the cost of imports.

s-m

A long period of strong consumerdriven growth in the West has come to an end.

From the mid-1980s— when oil prices fell sharply—until the mid-2000s, western consumers benefited from an environment of cheap imports from the rest of the world. Energy and other commodity prices remained subdued until the mid-2000s. And the expansion of the world economy to include new sources of low-cost production—including China and India—initially pushed down prices of many manufactured products and provided a further boost to western living standards. However, as these large emerging market economies have developed and grown, the tables have turned. Strong growth in Asia and elsewhere in the emerging world is now exerting more inflationary pressure across the world economy. The world of cheap imports has been eroded by successive waves of energy and commodity inflation since the mid-2000s. And strong growth in China, India and elsewhere is pushing up their labour costs and adding further to import costs for the UK and other western economies. The current era of high and volatile energy and commodity prices is unlikely to be a temporary phase. The ten largest economies in the Asia-Pacific region already account for nearly 30% of world gross domestic product (GDP)—making a larger contribution to the world economy than either the United States or the European Union. Over the first half of this century, Asia’s share of world GDP is likely to rise to around 50%[1]. As living standards in Asia continue to move closer to western levels rise and population growth continues, there will be continued upward pressure on the demand for energy and commodities, with new sources of supply struggling to keep pace.

s-m

A third change since 2007 has been in the ability of governments and central banks to underpin confidence in the private sector. Before the financial crisis, governments and central banks appeared to be able to support growth, contain inflation and maintain orderly financial conditions. This confidence has been severely dented by the experience of the financial crisis and the difficulty we have had steering our way out of a period of economic turbulence. Three tailwinds which supported growth for over two decades prior to the financial crisis—easy money, cheap imports and strong confidence— are no longer available to support growth in western economies. The UK and other western economies are going through a prolonged period of structural adjustment to the “new normal” world of more restricted finance and higher and more volatile energy and commodity prices. And this adjustment is likely to continue through the mid-2010s. A long period of strong consumerdriven growth in the West has come to an end and export opportunities in emerging and developing economies are now more likely to be an engine of growth, which is why exportoriented economies like Germany and Sweden have performed well relative to their European partners. Another aspect of the adjustment is that indebted consumers and governments need to adjust their spending and debt levels downwards to more manageable levels.

s-m

But even though the macroeconomic environment has become more difficult, there are still new opportunities arising—driven by technology, social and demographic trends and growth opportunities in Asia and other emerging market economies. While businesses need to be cautious about over-extending themselves in a volatile and uncertain environment, it would be unwise to totally neglect growth opportunities. At the same time, the adjustment to the “new normal” world implies further business restructuring— particularly in sectors heavily dependent on consumer growth in the UK and other western markets. So what does this mean for airlines and airports? What are the major adjustments which need to take place in the global aviation industry if it is to adapt successfully to this “new normal” world? The first major conclusion is that growth is likely to be relatively weak in the mature aviation markets of US and Europe and the major engine of growth will be the dynamism of Asia and other emerging markets. This is already evident in the IATA global air traffic data which show the US market up by just over 2% so far this year, compared with growth of nearly 6%–7% in the Asia-Pacific region, Africa and Latin America and double-digit growth in the Middle East. European air traffic growth is still benefiting from the development of low-cost budget airlines, but as that segment matures, growth rates should slow here too. Long-haul air travel is also likely to be a beneficiary of this shift in the centre of gravity of the global economy. As western businesses seek out new areas of opportunity in Asia and other emerging markets, new business travel flows are likely to develop. Trade between the EU and China, for example, has doubled since 2003—and flows of international trade and investment are major drivers of longhaul air travel for business purposes.

s-m

The “new normal” economy has a number of significant challenges for airlines and airports.

In my view, this is not a temporary phase. Since the mid-2000s, every time the emerging world and the major western economies have both been growing healthily, we have seen a major surge in oil prices, often associated with broader commodity price pressure. The first surge in 2003- 2005 took the oil price from around US$20 to US$50–US$60 per barrel. The second surge in 2006-8 took the price up to nearly US$150 per barrel, before it fell back to US$40 in the depths of the financial crisis. And from 2009–2011, the oil price surged again to over US$100 per barrel, where it has remained despite the recent weakening in the global economy. The IMF’s baseline scenario for the oil market is for a further rise to US$200 per barrel by 2020[1]. So the recent surge in oil prices may not be the last. And as the global economy picks up again from the recent weakness associated with the euro crisis, we could easily see a renewed surge towards $150 per barrel in 2014 or 2015. The “new normal” economy has a number of significant challenges for airlines and airports—changing sources of growth, continued volatility, and sustained high (and also volatile) energy prices. The industry players who are most successful at managing these challenges will be those who recognise and adjust to this “new normal” quickly. Those who are waiting for a return to the “old normal” of easy money, cheap imports and robust confidence will have a long wait. Those conditions are not set to return. And industry players who think these pre-2007 conditions will return risk not only disappointing performance, but ultimately extinction!

Dr Andrew SentanceAbout the author: Andrew Sentance is a Senior Economic Adviser at PwC and is a former Chief Economist at British Airways (1998–2006) and a former member of the Bank of England Monetary Policy Committee (2006–2011). He is based in London.Source:Pricewaterhouse